Equity volatility hits US leveraged loans

NEW YORK, Nov 23 (LPC) - Volatility in the equity and bond markets has pushed US secondary loan prices to levels not seen since 2016 and is putting pressure on deals in the market as investors demand better terms.

The SMi index of most-traded loans fell to 97.64 on November 21, which is the first time it has dropped below 98 since June 2016, according to LPC data. Prices are now 127bp lower than the year’s high of 98.91 on October 8.

Leveraged loan prices initially resisted the volatility, but the intensifying selloff that started in US technology and energy stocks has widened the gap between secondary and primary prices and is now prompting a primary market correction. The Dow Jones and S&P indices have dropped around 10% since the start of October.

Several deals for companies including online platform LegalZoom.com and food maker Hearthside Food Solutions had to price 25-50bp wider than initial guidance to clear the market this week. Secondary prices of jumbo benchmark loans are also languishing at sub-par levels, including the recently-completed US$9.25bn cross-border loan deal for Refinitiv, formerly Thomson Reuters’ F&R unit. Refinitiv’s dollar tranche was quoted at 97.5-98 on Friday.

A US$300m exit financing for Algoma Steel was pulled on November 19 due to market conditions, forcing the company to turn to an asset-based lending facility and a backstop facility instead of the exit financing.

Deals that are considered to be weaker or story credits are most vulnerable to changed market conditions as investors become more selective about credit. A split into ‘haves’ and ‘have nots’ is expected to become more pronounced as market participants try to close the year without incident.

“An increasing number of investors have taken their chips off the table as performance has been strong year-to-date - especially in loans - so why risk making mistakes in the last six weeks of the year?” a head of leveraged finance said. BUYING OPPORTUNITY?

With the year end out of the way, credit markets could rally in the first quarter even if the equity market remains choppy, bankers said as demand for floating rate loans remains strong in a rising interest rate environment.

Investors are attributing the equity sell-off to concerns over interest rates and a trade war with China rather than economic problems, as credit portfolios hold up against wider market gyrations for now, and some are already looking at the current situation as a buying opportunity.

“I expect the markets to rally nicely in the first quarter,” the leveraged finance head said.

Fitch Ratings anticipates the leveraged loan default rate in 2019 will be 1.5%, the lowest level since 2011. The default rate is currently 2.2%, although the prevalence of covenant-lite loans with fewer investor protections could make this a less reliable test going forward.

“Expectations for a dramatic increase in defaults is what will ultimately reprice the credit markets,” said Michael Terwilliger, portfolio manager at Resource Alts.

“The current default environment remains benign as the ‘Main Street’ economy is fundamentally sound and there is a nearly unprecedented pace of job creation. As long as the default backdrop remains sanguine, current volatility will ultimately prove to be a buying opportunity for investors,” he said. HARDER SELL?

Current market conditions and the 25-50bp pricing correction could make it more difficult for banks to sell loans that they underwrote in late 2018 and are holding over to syndicate in early 2019, including the US$10.2bn financing package backing the buyout of Johnson Controls Power Solutions unit.

Several deals had to sweeten terms to clear the market in the last two weeks. LegalZoom.com increased pricing on a US$535m six-year term loan to 450bp over Libor after initially circulating guidance of 375bp-400bp over Libor. The company is refinancing a US$325m first-lien loan and a US$105m second-lien loan with the proceeds.

The first-lien loan that LegalZoom.com is refinancing was originally priced at 400bp over Libor and the second-lien priced at 850bp over Libor in November 2017, according to LPC data.

Hearthside Food Solutions cut the size of a term loan to US$515m term loan from US$565m and increased a privately-placed second lien loan to US$300m from US$250m to cover the gap. Pricing on the deal, which backs the purchase of Greencore Group Plc’s US-based food business was also increased to 400bp over Libor from 350bp over Libor.

Telecommunications company Sprint Communications was also caught up in the melee. The company halved the size of a proposed term loan to a minimum of US$750m from US$1.5bn and increased pricing to 300bp over Libor from guidance of 250bp.

Volatility could, however, continue to give investors more bargaining power with private equity sponsors. Apollo made several concessions and improved investor protection on the US$4.975bn deal backing its buyout of hospital company LifePoint and increased pricing on an upsized US$3.55bn term loan to 450bp over Libor from 400bp in mid November.

Investors may continue to call the shots in the New Year after the market returns from the holiday period in a bid to improve the return on their risk and weak protection on loan documentation in a choppier environment for credit.

“I do think tightening documents will be a continued theme into next year,” the leveraged finance head said.